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For income funds, it’s their strategy that counts

How safe are your dividends? The answer can depend on the way you invest.

Stock market chart

by
Adam Carruthers

in Features

28.04.2020

As the Covid-19 pandemic causes extensive disruption to economies and businesses, listed companies have been shelving their dividend payments to conserve cash and try to keep their businesses solvent until the crisis eases.

Unlike the United States and Asian markets, the UK equity market has a legacy of delivering higher-than-average dividend payouts from its companies. For example, direct equity holders of UK major banking stocks have seen their dividends this year wiped out after the Bank of England (BoE) forced banks to cancel £7.5bn of payments. Barclays, HSBC, Lloyds, RBS and Standard Chartered generated an estimated 17% of FTSE 100 dividend income between them over the course of 2019.

The move added to the pressure on direct income investors and equity income funds after many sectors already cancelled or suspended dividend payments. Share buybacks have been halted by many businesses, including oil giant Royal Dutch Shell, as the price of oil trades at multi-year lows. Shell, the largest dividend payer in the UK stock market hasn’t cut its dividend since the Second World War. Indeed, Shell has already arranged for its credit lines to be extended so it can keep making the payment in the short term.

The cost of a bailout

Listed companies accepting the huge support packages on offer from the government may be prevented from paying dividends or conducting share buybacks in the future, the managers of the Artemis Income fund have warned. The popular fund is a good example of the open-ended fund structure that requires the distribution of all the income they receive to investors in any one year.

Artemis is now expecting and encouraging companies in which they have a stake to protect liquidity and slash dividends over the short term. While it would rather not see dividend cuts, it sees this approach as a better solution for medium-term prospects than a permanent dilution from companies that are forced to raise new equity at deeply-distressed share prices.

Importantly, active managers such as Artemis are also able to quickly spot attractive opportunities in companies disproportionately punished by the market. They also can (and do) invest in overseas-listed companies if the UK cannot offer the characteristics that they seek. Global diversification of income is now even more important than ever.

Closed vs open-ended funds

Historically, one of the key attractions of closed-ended investment trusts has been the greater dividend certainty that their legal structure has provided. They can retain up to 15% of gross annual income as revenue reserves, a feature not available to open-ended funds. During the bull market in equities of the past 11 years, which ended so abruptly in March, trusts have set aside millions of pounds of dividends received into these revenue reserves to underpin future dividends in circumstances such as the current pandemic.

Many investment trusts remain confident that they will be able to maintain or even increase their dividends. There are a number of trusts promoted as “dividend heroes” that have consistently increased their dividend over many decades. In addition, as a result of rule changes, many trusts now have the powers to pay out income from capital. Furthermore, trusts with a particular focus on quality companies with strong balance sheets and market positions, such as Finsbury Growth & Income, have had relatively low exposure to dividend cuts to date.

Dividend strategy is vital

However, the fall in income levels over the next 12 months will potentially be far greater than was the case during the Global Financial Crisis. It would be a naïve trust investor who blindly extrapolated dividend history into the current extraordinary environment.

Those who adopt a process of screening only for the highest dividend yield, without regard for the strength of the balance sheet or how much the dividend is covered by annual earnings, have always come unstuck when times get tough. Those who rely on a small group of UK-listed big dividend payers also end up being disproportionately hit in recessions.

Whether shareholders favour the simplicity of open-ended funds or the flexibility of investment trusts, those prudent investors who focus on lower initial yields – but one with the prospect of solid dividend growth from companies across all sectors with sound balance sheets, sourced from all around the world – can continue to ride out the difficult times when they come around.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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